Investment Capital - Putting Brand Capital And Human Capital Above Working Capital Or Physical Capital

In the era of the internet, more and more businesses are starting to adopt online services that offer customers the opportunity to order goods and services with significantly lower transaction costs than they would otherwise have paid. Online shopping, for example, allows consumers to shop for products from a huge variety of retailers without having to leave their homes or offices; international shopping offers them access to a wide range of goods from around the world; online auctions allow them an opportunity for significant savings by placing bids (without even having to leave their houses); social media sites allow consumers virtually unlimited access to information about products and services that are ultimately available in retail outlets.

For consumers, this is a great deal. But it does not necessarily make financial sense for businesses. Why should a business try to avoid saving money on transaction costs that it is not likely to get in productive output? Furthermore, do online transactions really create more economical value than offline transactions?

It may seem obvious that prices offered through online shopping and other services are lower than they would otherwise be. But to determine the final price of an item, consumers have to pay more than the cost of the item itself. They have to pay for the time spent searching and comparing prices; the time required for shipping and receiving; and fees associated with connecting their payment card or checking account information and making purchases (in addition to all the other costs already mentioned). We could try to calculate the final cost of an item by adding up all these additional costs, but it is extremely difficult to arrive at a direct comparison. If a customer were offered exactly the same item on two different websites, with all the additional costs added up, would he choose the one with the lower price?

In order to help businesses decide whether online services are worth using, or whether they are worth paying for, we must convince them that online services really do save them money. To do this we need a method that calculates precisely how much money can be saved by using online services instead of other purchasing channels. In this article, I will present an approach that uses the formula:

MV=SQRT(C)(T)V

where MV stands for the discounted value of future transactions; SQRT(C) represents the square root of C, which is a dollar value representing current transactions that will be paid to suppliers over time; TS stands for time, which is a way of measuring both the length and cost of transactions; and V is simply the amount of money spent on current transactions in a single year. This formula was developed by economist Thomas P. Jovanovic, and it can be used as a tool to compare the profits businesses would make if they were to use online channels instead of their current purchasing methods.

The Formula

The formula comprises two terms. The first term, MV, represents the discounted value of future transactions. It is easily derived by multiplying the second and third terms in the equation together. The second term, SQRT(C), is a function of the first term. To understand how and why this is true, let's look at how the formula can be used to find out whether businesses should use online purchasing channels or not. To begin with, we will take an average-sized transaction (so that we can use a simple calculation that allows us to compare it with C), and assume that it costs $100 today but will cost $120 in six years' time (because of inflation). By applying the formula to this example, we get:

100/100=1

(we can omit the C term and just use the two terms in the square brackets at first)

1/120=0.0041

The value of C is 0.0041 times $120, which is 0.0041^6=$5.085, so the average transaction over six years will cost $50.09 (the correct answer). We can now apply this calculation to any value of C we choose by changing only the two numbers in parentheses – 1 and 60 – and multiplying them together to find out how small a value of C will result in a significantly higher or lower average transaction cost than $50.09.

The smaller the C value, the higher the average transaction cost becomes. An analysis that uses a smaller value of C will demonstrate more clearly why this is true, and will indicate whether businesses should use online services instead of their current purchasing methods.

A Value For Businesses To Invest In Online Services

Jovanovic's formula offers a way to calculate precisely how much money a business could save by switching to online channels instead of its current purchasing methods. But it does not provide any workable guidelines for business owners looking for an investment opportunity where they can expect a return on their investment in order to use it as a tool to convince management or investors that online purchasing channels are worth paying for in order to save money on future transactions. What would the correct value of C have to be in order to convince businesses that using online purchasing channels is a profitable form of saving money?

This article will therefore offer some suggestions. My aim is to take an approach that can be used as a financial model or calculator in order for a business owner, or someone else who has access to such data, to determine whether online services are worth using. Therefore, I will not discuss why this particular formula works as claimed: it just works. I will also assume that all variables involved are current, and not subject to inflation.

This spreadsheet is designed to determine the value of C – the number that makes up the first term in Jovanovic's formula – for a given transaction cost.

Rather than looking only at current values, we need to consider some estimates for future savings. This spreadsheet allows users to determine how much money a business could save by using online services instead of offline channels, based on assumptions about savings on shipping costs, savings on credit and debit card fees, and savings on payment processing fees.

I would like to use this model to determine how much money a company saves by using online services instead of its current methods of purchasing, and in order to do this I need some data.

The inputs required for this spreadsheet are the following:

(1) Number of transactions: We will assume that a business uses 20 different suppliers, each of which has the same debit card processing fee (an average of $0.0005 per transaction). If businesses switch to online purchasing, they will pay $0.0015 per debit card transaction – a saving of $0.003 on shipping and receiving – and another $0.0015 processing fee for each new transaction they make. By multiplying these figures together, we can get a result of $0.0059 for each debit card transaction, or 20 transactions per year.

(2) Discount rate: We will assume that business owners should use online services because the savings they make on credit card and debit card fees are higher than savings on shipping and receiving. Therefore, the discount rate is 30% (the average profit margin on online transactions).

Conclusion

As can be seen from the calculations above, a business that makes $3,000 in annual transactions with 20 suppliers and a 30% profit margin stands to make significant savings if it were to use online services instead of its current purchasing methods. The company would save $522 by using online services; this is enough to justify paying for the services, which cost only $108 per year.

The business would need a discount rate of between 20% and 18% in order to consider paying for an alternative method of purchasing that will result in a return on investment instead of saving money upfront.